The Year Of Global Profit: Global Financial Markets Vindicate Principle Of Human Productivity

In my last column I showed you that when it comes to understanding global stock market returns for 2017, valuation is only a small part of the picture. What is the big part of the picture? Earnings growth. Over the long run, the largest driver of investment returns is the underlying productivity of the people working in the economy. Businesses gather people together to help them be more productive. That's the point of companies. As Nobelist Ronald Coase argued a century ago in The Theory of the Firm, business firms exist because putting people in the same organizations cuts down on the coordination cost which it takes to get them cooperating if they were not working for the same business. They are more productive together.

Let's imagine that we look at the year 2017 as though it were a gigantic field on which the investible nations have gathered their markets together. I introduced this form of chart in the last column. But in this case, they line these market indices from highest earnings growth for the year at one end, down to lowest earnings growth down at the other end. Then we have our indices march across the field, unfurling streamers behind them and rearranging themselves into order from highest annual performance during the year to lowest performing.

If performance rank during the year coincided well with rank in earnings growth during the same year, then the chart would look mainly horizontal. There would not be much crossing of lines, and especially not much crossing from top to bottom.

And that's what we saw in the year which just ended.

The countries below, arranged in order of greatest investment return to worst generally coincide with countries which had the highest corporate earnings growth.

In general, national indices that were among the top quintile of growers were among the top quintile of performers, and so on down to the bottom. Not a perfect fit, but pretty good one. This makes sense: We already saw that valuation was not a big driver of things and we know that there was not much interest rate suppression compared to some of the other years since the great recession. Something had to be moving these markets, and that something was earnings.

In fact, earnings tend to explain the previously unexplained anomalies we talked about last column. For example, the extremely attractively-priced Russia was a terrible performer. That’s because Russian earnings were the worst in the world last year, and Russia was the second worst performer. Israel was the worst or second worst in earnings growth and the worst in global performance. We saw in the last column that Poland was unattractively valued and yet a stellar performer; ditto for Chile, unattractively valued but a good performer. In both cases, earnings growth explains the paradox. Poland was by some measures the world's fastest earnings grower and also the world's best performer. Chile's South American neighbor Peru tells a similar story: Unattractive value goes together with high performance because of terrific growth.

When we take the same data as above and instead of arranging it by rank, test the correlation between two factors we see that the relationship is a great fit. In fact, there is a greater than 80% correlation between earnings growth and stock market performance during this same period.

When you take a principles-based approach to investing you’re more likely to do well over the long run, but it's important to remember that not every principle is equally important in every time period. The banner year we just left behind us was one where both value and earnings growth mattered, but earnings growth mattered quite a lot more.

The fund's investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus and summary prospectus (VIDI, VUSE, VBND) contains this and other important information about the investment company, and a free hardcopy of the prospectus may be obtained by calling 1-800-617-0004. Read carefully before investing. Holdings information for each fund as follows: VIDI, VUSE, VBND.

Investments involve risk. Principal loss is possible. The Funds have the same risks as the underlying securities traded on the exchange throughout the day at market price. Redemptions are limited and often commissions are charged on each trade. VIDI is non-diversified, meaning it may concentrate its assets in fewer individual holdings than a diversified fund. Investments in foreign securities involve political, economic and currency risks, greater volatility and differences in accounting methods. These risks are greater for investments in emerging markets. A fund that concentrates its investments in the securities of a particular industry or geographic area may be more volatile than a fund that invests in a broader range of industries. VIDI and VBND may invest in illiquid or thinly traded securities which involve additional risks such as limited liquidity and greater volatility. VBND may make investments in debt securities. The Fund's investments in high yield securities expose it to a substantial degree of credit risk. These investments are considered speculative under traditional investment standards. Debt issuers and other counterparties may not honor their obligations or may have their debt downgraded by ratings agencies. An increase in interest rates may cause the value of fixed-income securities held by the Fund to decline. During periods of rising interest rates, certain debt obligations will be paid off substantially more slowly than originally anticipated and the value of those securities may fall sharply, resulting in a decline in the Fund's income and potentially in the value of the Fund's investments. VBND may also invest in asset backed and mortgage backed securities which include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. The performance of the funds may diverge from that of the Index. Because the Funds employ a representative sampling strategy and may also invest up to 20% of its assets in securities that are not included in the Index, the Funds may experience tracking error to a greater extent than a fund that seeks to replicate an index. The Funds are not actively managed and may be affected by a general decline in market segments related to the index. The Funds invest in securities included in, or representative of securities included in, the index, regardless of their investment merits. Small and medium-capitalization companies tend to have more limited liquidity and greater price volatility than large-capitalization companies. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value.

The Vident Funds are distributed by Quasar Distributors, LLC. The fund's investment advisor is Exchange Traded Concepts LLC. VIDI, VBND, and VUSE's sub-advisor is Vident Investment Advisory (VIA). Vident Financial owns the indexes that underline the funds. Quasar is not affiliated with Vident Financial, Exchange Traded Concepts, or Vident Investment Advisory. Quasar is not the distributor of FLAG ETF.

Diversification does not guarantee a profit or protect from loss in a declining market.